Sunday, March 29, 2015

A misguided attack on Land Value Taxes

The idea of a Land Value Tax (LVT) is to tax the value of land independently of the value of improvements on that land (e.g. buildings, farms, or mines). Separating the value of a plot of land from the value of the structure built on top of it is a very difficult thing to do, since you can't usually observe the value of a piece of land both before and after the improvement is made. This implementation issue is the main problem with the LVT.

Periodically, people make criticisms of the LVT, and they usually boil down to this measurement problem. For example, Zac Gochenour and Bryan Caplan go to great lengths to show that a tax on the value of unimproved land reduces the incentive to search for better improvements. But under a true LVT, improvements would receive a tax credit, which would remove this problem entirely - if, of course, you can measure the value of the improvement. (Actually, in the case Gochenour and Caplan describe, the measurement of the value of the improvement would actually be easier than usual, since you could do a before/after observation.)

Adam Ozimek of Forbes has another argument against the LVT, which he claims doesn't boil down to the measurement problem. But I think his argument is mistaken. Adam writes:

[T]here are a significant amount of spillovers in local real estate investment. Land value is not just capitalized value of publicly provided public goods, but of nearby privately provided positive spillovers. It’s widely recognized that when individuals clean up a property, or open a popular business, there are often spillover values in the neighborhood. Urban economists recognize that the collective value of these spillovers is huge, and in fact makes up a significant amount of land value.

The fact that private amenities have positive spillovers suggests that they will be underprovided by competitive markets. However, by allowing some of the value of spillovers to be captured, higher land values provide real estate developers, businesses, and even households with incentives to create them.

The value of unimproved land does increase with improvements on neighboring land. But this does not mean that land value allows a landlord to capture the value of the spillovers created by his own investment. It does not.

Suppose there are two adjacent plots of initially undeveloped land, A and B. A is owned by Andy and B by Barbara. Andy pays for a nice house on plot A. This raises the value of plot B, and enriches Barbara. If no Coasean side payments are made, then Andy fails to capture the value of his investment in the nice house. Barbara gets a windfall from Andy's investment.

Now suppose there is a 100% LVT. When Andy builds his house, he pays no additional tax. But Barbara pays some tax - she pays the full value of the windfall she received from Andy's investment. Andy's incentive to build the house on plot A is unchanged under the LVT. And Barbara's incentive to build a house on plot B is likewise unchanged.

So I think Adam's critique is just mistaken.

But, you may ask, what if there is a spillover not to the value of Barbara's land, but to the value of her potential future improvements? Adam raises this possibility later in his post:

Real estate developers who move into neighborhoods with high vacancies, low demand, and high crime are often hoping that positive spillovers from their investment will spur additional investments from others, which will in turn make their investment more valuable.

This is easy to fit into the example above. Suppose the value of a house on plot B is 1.5 times as high if there is also a house on plot A. That's realistic, since a plot of undeveloped land may make a neighborhood less attractive. In this case, isn't Andy overtaxed by the LVT?

No. His incentive to build the house is exactly the same as it would be without the LVT, since without the LVT he would also fail to capture the spillover benefit on Barbara's improvements. There is an uncompensated positive externality, but it's no bigger with the LVT than without it.

In other words, the problem of neighborhood externalities is a thorny one, but the LVT does not make it worse (or better). The big problem with the LVT remains the measurement problem. Of course, that problem cannot be waved away.

Updates

Just to formalize the above intuition a little more, here's the Andy-Barbara example as a 2-person game. Define:

HA = the value of a house on plot A when there is no house on plot BCA = the cost of building a house on plot ALA = the increase in land value of plot A when there is a house on plot BNA = the increase in the value of a house on plot A when there is a house on plot B
Without loss of generality let the value of a plot of land be 0 when there is no house on the other plot.

Each player decides whether to build a house or not. With a land value tax, LA=LB=0. Here are the games with and without a land value tax:

You can easily see that the condition for (Don't Build, Don't Build) to be a Nash equilibrium in the first game is the same as in the second game - namely, that H-C < 0 for both players.

You can also see that the condition for (Build, Build) to be a Nash equilibrium in the first game is the same as in the second game - namely, that H-C+N > 0 for both players.

Therefore, the presence of an LVT won't affect the outcome of which houses get built. This outcome also doesn't change if you make the game sequential.

On a related note, people on Twitter read this post and started bugging me to cite empirical work, which I had previously failed to locate. But I looked again, and this time I found a couple things. For instance, there was a 1997 study in National Tax Journal that examined Pittsburgh's experiment with an LVT in 1979-1980. The study found that the LVT increased building activity. A 2010 study in the Journal of Urban Economics found similar results when examining a number of LVTs implemented in cities in Pennsylvania; not only did LVTs increase the supply of housing, they also increased density.

It does deserve deeper thought.The largest landowners in the UK are:Forestry CommissionNational TrustMODPension FundsUtilitiesCrown EstateRSPBDuke of BuccleuchNational Trust - ScotlandDuke of AthollJames DysonQueenDuke of Bedford

I've never understood why it's a Land Value Tax - why not just per square yard/acre or whatever?Also, in the UK we'd have to sort out planning first so that we got a "correct" no. of dwellings built. We'd also have to look at the agriculture subsidies. Both of these things act to distort a true free-market value of land.

" This implementation issue is the main problem with the LVT" Except that many countries have had such taxes for >100 years, so it really isn't a problem in practice. Here in Queensland, Australia we have a particular court (formerly the Land Court), where disputes over land valuations were settled. For the vast bulk of land values it is very easy to estimate land values, and there are established accepted methods for doing so.

Ozimek's argument appears to be the opposite of a common criticism of LVT: Barbara builds a nice house on her property, then Andy comes along and builds condos on the adjacent parcel. The condos create a spillover back onto Barbara's property, pricing her out because of the tax. Barbara is forced to sell the parcel or further redevelop the property despite just having built a house. As with many LVT criticisms it's a little farfetched and doesn't address the principles.

As for separating land from buildings, I don't think it's nearly as thorny a problem as you suggest. The NY Fed did this for NYC several years ago (pdf), and subtracting building replacement costs from purchase prices of old improvements isn't that difficult.

That argument -- the "Barbara" one -- bothers me so much. The only reason the value of her property and therefore LVT would spike is if she was had the poor sense to build her house on a parcel zoned for multi-family development, e.g. condos. Then she deserves to take the hit because she is excluding possibly hundreds of people from a place to live.

I think you were just saying, "This is what other people say," so this isn't against you; it's against whoever says it. :)

There's not much difference between this and a LVT. Trying to capture 100% LVT sounds great - but it reduces liquidity - the goal is to reduce the level of comfort that real estate guys have with holding land in up markets for too long.

I'm a huge LVT fan, all Libertarians have to be a bit of a georgist. It's the very best kind of consumption tax. The very first money a state should collect.

The problem is that most of LVT noobs all imagine somehow that LVT = get moar bigger govt! They aren't really focused on moral reason for LVT, they assert it, but they don't believe it.

Because Hauser's Law is far stronger an American fact.

And when you suggest YES!! Let's go to LVT and get rid of corporate income taxes, they fight like a dog to say no.

But a true believer of LVT, simply says SURE! Let's get our tax system straight and growth oriented.

"The fact that private amenities have positive spillovers suggests that they will be underprovided by competitive markets. However, by allowing some of the value of spillovers to be captured, higher land values provide real estate developers, businesses, and even households with incentives to create them. "

Or let's take this to the extreme. Let's say I buy 1500 square kilometers of barren land (the area of London) and out of my own pockets build a City with everything in it. Because I've built it so well, 10 million people move in. The rental value of land has now gone from zero, to $200 billion per year.

As the provider of the capital, should I pocket that $200bn per year rental income, or should it be taken away as an LVT?

Say if I situated my city in Outer Mongolia an no one wanted to move there? The land would still be worth zero. If in theory I could dismantle the capital improvements they'd still have a value though.

The point being, it is the scaling effect of agglomeration (large, dense population) that gives rise to a productive surplus. In order to tap into that surplus you need to be situated as close as possible to it. Usually in the middle.

So, land users do not create that surplus they tap into it. Like oil producers drilling into deposit.

Supply is created, demand is simply shifted. But the idea that demand is created like supply is one of the most pervasive memes in our culture.

It's quite simple. As no one created Land, no one has a right to exclude others with out paying compensation to those excluded.

Only then can we have a fair distribution of all the factors of production.

Zac Gochenour and Bryan Caplan in their ideological zeal to disprove the efficiency of an LVT didn't even bother to think/research what Land actually means.

Unfortunately they mistakenly define Land with a small l, that is physical land.

When in fact it has a precisely defined economic meaning. Land is all that is not produced by human effort.

So, they conflate information and sunk costs, which are Capital, with Land in order to show a tax only on the unimproved value of physical land would incur a deadweight loss. Which in certain circumstances it would. But that wouldn't, by definition be a Land tax.

I'm not sure if they are just lazy, stupid or dishonest. But whatever it is, it is typical of the risible critiques of Geoism by academic economists.

I think what Ozimek meant was that Andy's investment in improvements will raise his LVT because land value measurement generally is based on comparison to neighboring plots.

In other words, compared to a full property tax, LVT would create less disincentive to invest in improvements, but compared to no property tax, LVT would still create some disincentive. And LVT would be subject to some arbitrary weirdness, more so than full property tax is.

I'm sure I'm missing something, but doesn't the LVT increase the incentive for each of Barbara and Andy to keep the other from building a house?

Locally, it's not unusual to hear people argue against building bigger, better, newer stuff because they believe that doing to will drive up rents and property values and force out less affluent neighbors. I generally think that gets the dynamics of supply and demand wrong.

But here, Andy's building a house will directly cost Barbara in LVT. He better hope she's not too tight with her city council members if he wants to get approval to build.

(Apologies if this comment shows up more than once as I've had trouble logging in and posting)

That's actually an interesting point though. Property owners have a lot of tools to block local development (see: Nimby et. al.) What would it mean if surrounding owners have a direct financial incentive to prevent their neighbors from making improvements to their properties. Currently it can be quite amazing how hard some will fight to block development even when their property values will rise as well and so they have a direct incentive to support development. Not sure this is that strong an argument against LVT, but unintended consequences...

When less affluent individuals are priced out of an area it's called gentrification and there are studies on alleviating this unnecessary stress as well. When the lvt camp and the gentrification camp come together it will be seen that the only reasonable thing to do with lvt revenue is to redistribute it back to the people equally in the form of a land dividend. User fees are the least distorted way to fund public infrastructure and services but only after a100% lvt is implemented. 100% redistribution of the lvt equally to all individuals is the only way to fulfill the concept of equal ownership of the earth among all peoples and use fees for needed or perceived needed government infrastructure and services is the only way we each take full responsibility for the infrastructure and services we use.

Sun Yat Sen had a great method for valuation: self-reporting. You tell the city what your land is worth to you. If you say it's $100K, you pay tax on that amount. The city has the right to expropriate the land at the value you give it. So if you underreport, you run the risk of losing your land.

That's not self-reporting determining the valuation. That's the market setting the valuation. The land value you declare is essentially the ask price. You can open up the right to purchase the land not just to city and local governments, but to private individuals in the wider public as well and create a market valuation for the land. Land owners would thus have an incentive to value their land at market prices.

I've been wondering, couldn't the arguments for the LVT be generalized to all assets in the economy? Land is special because it is an especially inelastic good, but it seems that all assets, not just land, derive at least some part of their value from the fact that they are rivalrous. If there were some magical machine that could replicate and distribute any and all goods instantly to everyone, then the market price of a unit of a good be zero. The market value of any asset in the economy derives at least some of its value from it being rivalrous, and its rivarly is established by property rights, which are maintained by the government. So part of the value of every asset, not just land, derives from the economic rent of the asset resulting from the government's provisioning of property rights.

We have an LVT built into our property tax in my suburban Washington DC country. The assessment is in two parts: the value of the dwelling and the value of the property. Our 1955 split level house has not appreciated much in the almost 30 years of ownership whereas the land value has. Nobody who would want to buy our house would do so for the dwelling, only the land.

Perhaps this is merely another manifestation of the measurement problem. But if you expropriate all of the land rent, you also eliminate the incentive to allocate the land to its best and highest use. Instead, if you were the landowner, you would merely maximize the NPV of the improvement. Successful LVTs are not 100% LVTs.

Land value doesn't derive from the "best and highest use" of the land. That's why a plot of land can have land value and rise dramatically in value despite absolutely no economic activity taking place on the land.

Maximizing the NPV of the improvements on the land or of the economic activity that can take place on the land such as a factory or an office providing services, is the "best and highest use" of the land.

Where is it written that under a true LVT improvements garner tax credits? That's a new one on me. People talk about credits to ease the transition burden on small property owners (the property, not the owners). Those interested in this may want to know the Lincoln Institute in Massachusetts is your go-to place on this topic.

Measurement is always imperfect. One of my favorite sayings is from Bill Vickrey: "Every rule violates a principle." To do taxes you need rules.